Fed QE3-Tapering Impact

The Federal Reserve's upcoming decision on whether to slow its third quantitative-easing
campaign's debt monetizations has to be this year's most-highly-anticipated
market event. Traders have been trying to game the odds of QE3 tapering literally
all year long, driving some sharp market moves. So the Federal Open Market
Committee's decision due out next Wednesday is likely to be a major market-moving
event.

The focus on this imminent FOMC meeting is so hyper-intense that its impact
should be considerable no matter what the Fed decides. The QE3 taper (or lack
thereof), its size, and what the FOMC implies for future tapering will almost
certainly spark sharp price reactions in the bond markets, currency markets,
stock markets, and precious metals. All have moved violently this year
on mere QE3-taper anticipation.

There are strong arguments on both sides of the Fed starting slowing down
QE3 next week or waiting until later. With Fed Chairman Ben Bernanke due to
retire on January 31st, most believe he really wants to start unwinding his
unprecedented quantitative-easing programs on his own watch. He is worried
about his legacy, how history will view the largest debt monetizations ever that
were his brainchild.

Bernanke has spent months painstakingly telegraphing to traders that he'd
like to start slowing QE3 at this September FOMC meeting. If the Fed doesn't
taper after setting expectations so high, it is going to take a big credibility
hit with the markets. Not tapering will likely also be interpreted by traders
as the Fed viewing the US economy as deteriorating, which could spark a big
stock-market selloff from lofty
heights.

Tapering QE3 is probably less risky at the FOMC's September 18th meeting than
its next October 30th one because the former is one of the four per year (out
of eight) that are followed by a Bernanke press conference. So if the market
reaction is adverse to the taper, Bernanke will have a chance to explain the
FOMC's thought process soon after the decision. Thus most traders believe tapering
begins next week.

But this decision is far more complicated than Bernanke's comfort and the
Fed's credibility. Between the FOMC's May 1st meeting and last week, mere QE3-tapering
fears have catapulted the benchmark 10-year US Treasury yield from 1.66% to
2.98%! This epic 4/5ths rally in yields is the result of a massive bond
rout. Bond investors are fleeing Treasuries, worried that the dominating buyer
(Fed) is pulling back.

Higher bond yields wreak havoc on the economy, driving up all borrowing costs.
This is particularly important in the mortgage markets, since the housing recovery
is absolutely essential to US jobs growth. Since the mere threat of the Fed
slowing its QE3 Treasury buying sparked a colossal bond selloff, can it risk
the actual event driving yields even higher? Unemployment will surge again
if house buying slows.

Higher interest rates are a huge threat to the US government too. Under
Obama the national debt has exploded
higher, yet the Fed's record-low interest rates still led to very low debt-servicing
costs. If yields on Treasuries merely return to their 40-year average before
Obama, the total federal interest costs alone on today's debt would
skyrocket by 5x! This would consume most discretionary spending, sinking the
government.

Higher yields also risk triggering a
bear market in stocks. One of the Fed's goals through manipulating yields
down as low as possible was to force investors into risky assets like stocks.
As rates rise, bonds become far more attractive again for new buyers. So
higher yields could ignite an exodus out of the stock markets by investors
worried about the risks posed by the very tired and overextended cyclical
stock bull.

The FOMC has foolishly painted itself into a very dangerous corner. It is
probably damned no matter when it starts tapering QE3, with serious market
disruptions likely. While bonds are ground zero, and currencies will closely
follow, my primary interest as a speculator is in the American stock markets
and precious metals. Whatever the Fed chooses to do next week is likely to
have major impacts on them.

To better understand their potential, we have to consider how the FOMC and
all its QE3-tapering talk have affected them so far this year. This chart looks
at the flagship S&P 500 stock index (SPX) and gold. All 2013 FOMC-meeting
decisions are highlighted in black, with their subsequent minutes noted in
yellow. Most of the biggest and fastest moves in stocks and gold this year
are highly correlated to the FOMC.

Before QE3's birth last September, the US stock markets' tired
cyclical bull had been topping. Despite multiple attempts, there hadn't
been a single new high for over 5 months. But first on a European Central
Bank decision to monetize bonds a week earlier, and then on the Fed's QE3
announcement, the SPX finally broke out to new bull highs. It was the Fed's
first-ever open-ended quantitative-easing campaign.

The timing of this decision was highly suspect politically. It was less than
8 weeks before the critical 2012 US elections. And throughout US presidential-election
history, the results have had a
very high correlation with the stock-market action in the Septembers and
Octobers leading into them. When the SPX is up over that final 2-month span,
the incumbent party has won 94% of the time. If down, it has lost 83% of the
time.

So Bernanke goosing the stock markets right ahead of a major election, greatly
raising the odds they would be higher (and they were), almost certainly gave
it to Obama. Remember that Republican lawmakers had been aggressively attacking
the Fed for its QE2 debt monetizations, so the Fed faced serious political
risks if the Republicans regained power. QE3 was shrouded in controversy from
its birth.

At its mid-December meeting, the FOMC decided to expand QE3 to include monthly
Treasury buying on top of the original mortgage-backed-security buying. The
minutes for that meeting were released several weeks afterwards as usual, in
early January. Incredibly at the very meeting where the FOMC launched
its QE3 expansion, there was already much internal dissent. Thus 2013's QE3-tapering
debate began.

Literally since January 3rd, when the Fed would start slowing QE3's rate of
purchases has probably been the dominant driver of global financial-market
sentiment. Ever since every FOMC meeting, all their minutes subsequently released,
and even each speech by individual Fed officials have been carefully scrutinized
for QE3-tapering implications. Whenever QE3 tapering seemed more likely, big
selloffs arose.

This is especially true in bonds, but our focus here is on the stock markets
and gold. While other factors were at play, primarily the levitating SPX sucking
capital out of the American GLD gold ETF, gold suffered its first sharp
selloff in February soon after the late-January FOMC meeting. The subsequent
minutes in late February saw the SPX sell off sharply. Then gold's next selloff
started cascading at the mid-March meeting.

Both the SPX and especially gold then plummeted when its minutes were released
in mid-April. Some of the FOMC members thought QE3 tapering would start by
mid-year and finish by year-end. Unfortunately for gold, these very minutes
drove the metal right down to its critical $1550 support line. That soon failed,
unleashing an ultra-rare futures
forced liquidation that crushed the gold price in an unprecedented way.

Gold's subsequent bounce from this panic-like plummet was cut short by the
FOMC's next meeting in early May. And the minutes of that meeting released
in late May started the biggest pullback in the SPX's levitation so far. Then
both the SPX and gold plunged dramatically at the FOMC's next meeting in mid-June,
which happened to be followed by the press conference where Bernanke laid out
his QE3-tapering plan.

Then again the SPX topped soon after the FOMC's latest late-July meeting.
As you can see above, the great majority of this year's biggest and fastest
moves in the SPX and gold were highly correlated with either FOMC meetings
or their subsequent minutes. Charts of bond yields and the US Dollar Index
show similar strong reactions to the odds of QE3 tapering rising and falling.
It has dominated global markets this year!

Seeing how the stock markets and gold reacted to the mere idea of QE3 tapering,
how will they react next week (or later) at the actual event? There is a universal
assumption among traders today that QE3 tapering is fully priced in for
stocks, so the price impact will be minimal. Everyone also assumes that gold
is going to get obliterated by QE3 tapering, which is understandable given
its horrendous Fed reactions this year.

This popular consensus may certainly be right, after the Fed starts slowing
QE3 the SPX will keep on climbing higher forever and gold will plunge to zero.
But ever the contrarian, I always want to take the opposite side when nearly
everyone is convinced of certain outcomes. What if the levitating stock markets have
not priced in a QE3 taper, but gold far more than has after being pummeled
so mercilessly?

Despite QE3-tapering fears driving periodic pullbacks, there is no arguing
that QE3 has been exceedingly good for the SPX. Between the day before it launched
and this week, this flagship stock index has soared 17.6% in exactly one year.
This extended its already-old-and-big cyclical bull born in March 2009 to an
astounding 152.7% gain. It also pushed its span since a correction to 22 months.

These metrics far exceed healthy averages. The average cyclical stock bull in
a secular bear doubles in 35 months, our current specimen is up 152.7%
in 53 months! Healthy bull markets see full-blown corrections (selloffs in
the high-teen percentages) once a year or so, now we are up to nearly two
without one. There's a strong case to be made that QE3 was the primary driver
of 2013's extraordinary SPX levitation.

If QE3 was so great for stocks, how can its slowing and eventual stopping
also be great for stocks? How can the QE3 taper be already priced into the
SPX when this index has kept powering higher all year long even despite periodic
QE3-tapering fears? With the mere threat of QE3 tapering spawning sharp pullbacks,
won't the actual event also trigger a big selloff? This QE3 tapering is hyper-risky
for stock markets.

Gold on the other hand has already been annihilated on futures traders'
intense obsession with QE3 tapering. In the year since QE3 launched, it has
been pummeled down 21.2%. The second quarter in particular was monstrously
brutal, gold's worst in something like a century. The gold selling triggered
by and exacerbated by Fed QE3-tapering fears was wildly unprecedented on virtually
every possible front.

Gold's incredible selloff during QE3 is a mind-boggling anomaly. Quantitative
easing is a happy-sounding euphemism for debt monetization, the highest-octane
form of monetary inflation there is. When the Fed buys bonds, it simply creates
the money to do so out of thin air. And in the case of Treasuries, the
federal government spends this new money almost instantly which directly injects
it into the real economy.

QE3 is a massive open-ended inflationary event unparalleled in history. And
gold thrives in inflationary times, it is the ultimate inflation hedge. During
the lifespans of QE1 and QE2, gold powered higher by 50.8% and 24.7% respectively.
So to see it down 21.2% so far during QE3 utterly defies belief. It makes no
sense at all, absurdly illogical. And like all market anomalies, this one is
super-overdue to reverse.

Gold plummeted 26.4% in the first half of 2013, with QE3-tapering fears playing
a major role. They helped shape the psychological backdrop that led to the mass
exodus from GLD. With such a wildly unprecedented gold selloff, isn't it
highly likely that QE3 tapering is long since priced in? Will this critical
investment class keep plunging forever simply on fears about how fast the Fed
will wind down QE3?

Gold-futures traders, who are excessively fixated on the QE3 taper, are totally
looking at the wrong side of it. What they should be paying attention to is
the Fed's mammoth balance sheet! Every dollar of bonds the Fed purchases
is a direct injection of monetary inflation. And as long as QE3 exists at all,
this metric is going to keep growing. This next chart takes a look at
the incredible inflation quantitative easing has baked in.

This chart is stacked, showing the Fed's holdings of Treasuries (red) and
mortgage-backed securities (yellow) within its total balance sheet (orange).
Across it are noted key dates of FOMC meetings where major policy changes were
made including quantitative easing. This gigantic and growing balance sheet
is what gold-futures traders should be focusing on, not a trivial change to
the rate of QE3's growth.

Before uber-inflationist Ben Bernanke launched the original QE1 and forced
interest rates to zero in late 2008, the Fed's balance sheet was around $890b.
It has ballooned monstrously since thanks to the bond-buying campaigns of QE1,
QE2, and QE3. All three of these were launched initially and then soon expanded.
Between these debt-monetization sprees, the Fed's bond holdings slowly shrunk
through maturing.

Before QE3 was launched last September, the Fed's balance sheet was sitting
at $2798b. Last week nearly a year later (the Fed's data lags by a week), it
had soared to $3607b! This is a colossal 28.9% increase in the Fed's total
bond holdings in merely a year, incredible amounts of inflation unleashed from
an already very-high base. Does it make any sense at all for gold to fall by
over a fifth during such an event?

It wasn't like gold was overbought in September 2012 when QE3 was born, which
could explain poor subsequent performance. This metal had peaked 13 months
earlier and was stuck in a high consolidation ever since by the time QE3
launched. Over that span it was already down 8.5%. So there was no reason at
all for gold to get hammered during an epic inflationary explosion of QE3's
magnitude.

Back at his press conference right after the FOMC's mid-June meeting, Bernanke
rocked the markets by laying out a very specific best-case QE3-tapering
plan. It proposed starting the taper later this year (which was interpreted
as the September FOMC meeting) and ending it entirely by mid-2014. He took
great pains to emphasize this was data-dependent, that QE3's pace could still increase if
economic conditions worsen.

But let's assume QE3 plays out like Bernanke hopes. This month will still
have $85b of purchases that will be added on to the balance sheet. Assuming
an even taper, the average monthly monetizations between now and the end of
June will be half that or $42.5b. Multiply those 9 months by $42.5b and you
get another $383b of bond buying on top of September's $85b. That means QE3
has $468b of buying left!

So far as of the end of August, QE3 is at $440b in mortgage-backed-securities
buying and $360b of Treasuries buying. The total is already $800b, which is
much larger than QE2's $600b of new buying. But add the additional $468b of
buying on top of that in a best-case taper scenario, and QE3 is still destined
to grow over half-again as large as it is today. It will propel the
Fed's balance sheet over $4050b!

Thus even in Bernanke's best-case QE3-tapering scenario, there is vast monetary
inflation left to come. With QE3 all but guaranteed to ultimately exceed $1250b,
and go much higher if there are any economic hitches, is it reasonable to expect
gold to keep falling forever? No way. Beyond futures traders' paranoid gut
reaction, QE3 tapering shouldn't be bearish for gold. This metal should soon soar on
the rest of QE3!

I suspect the probability nears certainty that gold will be considerably
higher when QE3 ends than it was when it begun. It's hard to believe,
but the day before QE3 was born this metal was near $1733. For all of human
history, inflation has been very bullish for gold. 2013's selloff, the psychological
groundwork of which was laid by QE3-tapering fears, was a wildly unprecedented
anomaly. And all anomalies reverse.

The contrarian view on next week everyone thinks is crazy is that QE3 tapering
will be bad for stocks and good for gold after the initial reactions. It's
hard to fight the crowd and think differently, but that is the only way to
consistently buy low and sell high. At Zeal our contrarian approach has driven
big gains. As of the end of June, all 655 of our stock trades recommended to
our newsletter subscribers since 2001 have averaged annualized realized gains
of +28.6%!

We have long published acclaimed weekly and monthly newsletters
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The bottom line is the Fed's coming QE3 tapering is likely to have a major
market impact. The hyper-overextended stock-market levitation is unlikely to
survive the Fed reducing its debt monetizations and resulting interest-rate
manipulations. Less Fed bond demand means higher yields, giving investors forced
into stocks by the Fed a chance to earn yield income again. Their stock selling
should snowball.

And despite gold's merciless hammering this year on QE3-tapering fears, that
anomaly doesn't change the fact that QE3 is massive and growing. Just like
during QE1 and QE2, sooner or later gold will react to the enormous inflationary
growth in the Fed's balance sheet. Even if Bernanke's best-case ideal timeline
for tapering QE3 is followed, there is still colossal bond buying coming between
now and next summer.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
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and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
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